Peter Oborne is the Daily Telegraph's chief political commentator.

Things can only get worse – but George Osborne mustn’t lose his nerve

The Chancellor’s programme of deficit reduction is under threat (Photo: Bloomberg)

At first, all went well with the austerity package unveiled by the Thatcher government after it took office amid the general collapse of 1979. Sensible people grasped that it was necessary to double VAT to 15 per cent. Even Sir Geoffrey Howe’s Budget of 1981, setting out his famous Medium-Term Financial Strategy of eye-wateringly tight monetary policy and spending cuts for years to come, was scarcely opposed by a demoralised Labour Party.

It took time for opposition to build, but build it certainly did. Unemployment refused to fall, business failures mounted, the initially supportive Financial Times panicked, calling for more “compassion”, and then the CBI ducked and ran for cover. The trade unions – more powerful than today – planned strike action. The BBC was nakedly hostile, while fashionable café society mocked the Thatcherites. A series of leaks emerged from the Cabinet, designed to undermine and destroy the prime minister.

By the summer of 1981, an atmosphere of crisis prevailed. Nationwide riots (the worst were in Toxteth and Brixton) vied with the royal wedding for newspaper headlines. Suddenly, Margaret Thatcher was no longer seen as a saviour, but rather as a monster set upon destroying our national fabric. Though hard to credit today, consensus opinion held that the government would fail and that Michael Foot, the newly elected Labour leader, was destined to enter Downing Street.

It was an incredibly hard time for Sir Geoffrey (who has a powerful claim to be Britain’s greatest post-war chancellor), but with the unstinting support of a superb prime minister he survived, pulled through, and bears much of the responsibility for the long British economic miracle which came to such a spectacular end in 2008.

Eighteen months on from the general election of 2010 and George Osborne has not yet reached his crisis point. But it is drawing nearer all the time – the danger signs are there. From within the Government come reports of Cabinet-level demands for a loosening of spending restraint. Indeed, the last month has been the most dangerous of Osborne’s short career as Chancellor. One piece of dark news has succeeded another, and he is reaching the moment of truth when his carefully crafted economic policy will face very searching and potentially deadly questions.

On Wednesday, the International Monetary Fund cut its growth forecast for Britain for the third time in less than 12 months, down to 1.1 per cent, compared with a 2 per cent projection at the start of this year. Before that came news that unemployment is sharply on the rise, while inflation is romping ahead, up 4.5 per cent in the year to August and out of control.

These are wretched statistics, symptomatic of a failing economy – and it is important to bear in mind that things could get very much worse if financial disaster strikes the eurozone in the coming months. Such an event would alter for good many aspects of Britain’s society and its economy, change the assumptions that govern all our lives, and transform politics in ways that cannot be predicted. But even assuming that unhappy outcome can somehow be averted, most of the calculations made by the Coalition as it took power early last summer are already in ruins.

Let us consider Iain Duncan Smith’s programme of welfare reform. Duncan Smith surely deserves to succeed, but his tough-minded programme of taking the long-term unemployed off benefits and into work has no chance while the jobless count spirals upward.

But the most immediate threat is to the Chancellor’s programme of deficit reduction, and in particular his flagship pledge to bring the structural deficit back to equilibrium by the end of this parliament. When he made his promise, George Osborne was relying on growth forecasts presented to him by Robert Chote, head of the newly created Office for Budget Responsibility. Chote, a former director of the Institute for Fiscal Studies, is very highly regarded. But he has got off to a shocking start. He told the Chancellor that economic growth this year would come in at 2.6 per cent. Now that is unattainable and his projections for the years ahead look equally over-optimistic.

Chote’s error impacts directly on Osborne’s financial plans. A vicious spiral is at work. Lower growth means lower tax revenue, while higher unemployment means higher welfare costs. Nor is that all. Chote’s view of inflation has been far too sanguine, and here too the consequence for government spending is troubling.

David Cameron’s election pledge to maintain the rate of spending on the National Health Service “in real terms” looked relatively safe with inflation projected at 2 per cent. At 4.5 per cent and surging, Cameron’s promise will add billions of pounds to future government spending, money that has not been accounted for.

And bear in mind that the past 18 months have seen a series of U-turns, from NHS reform to forestry privatisation. Each one carries a cost, so it is no wonder that government accounts are being thrown into chaos, creating a crisis at the Treasury. Barring an incredible upturn over the coming months, Osborne will be faced with a hideous dilemma.

Either he must abandon his pledge to eradicate the deficit, thus doing irreparable damage to his reputation for sound economic management, or he faces the humiliation of returning to the House of Commons with a second emergency Budget, proposing a fresh set of spending cuts. The choice cannot be dodged. And whichever decision the Chancellor makes carries heavy consequences.

If he presses ahead with spending cuts he will create the first major fracture in the Coalition. Vince Cable – viewed within No 10 as a renegade loudmouth – is already mutinous, discontented and privately agitating for an alternative economic strategy. At some point, probably not far off, he will resign as Business Secretary, perhaps returning quietly to the Lib Dem backbenches, more likely forming a tacit alliance with Ed Miliband and Labour.

But if Osborne doesn’t press on, the dangers are greater. So far, Osborne has been a strong Chancellor who carries genuine credibility in the City of London. That credibility is of fundamental importance because it means that, unlike Italy or Spain, we can finance our national debt at cut-price rates in international markets – the essential point which the expansionary shadow chancellor, Ed Balls, fails to understand. If Osborne loses that credibility, it is not just the Coalition that is sunk – Britain is too.

A mood of optimism hangs over the Government this weekend. The Liberal Democrat conference has been an unexpectedly cheerful affair, with Nick Clegg more securely entrenched as leader than looked likely when the AV referendum was lost earlier this year. As Ed Miliband fails to make real headway, the field still belongs to David Cameron, stronger and more confident in the wake of the apparent success of the Libyan intervention.

But only one thing matters this autumn – the failing British economy and the unenviable decision that George Osborne now must make. The task confronting the Chancellor over the months ahead, as the international outlook darkens further, is at least as challenging as the one which faced Sir Geoffrey Howe in 1981, probably more so. Very difficult and uncomfortable times lie ahead for all of us.